One of the key reasons for producing financial information in terms of the balance sheet, profit and loss account and cash flow statement, is to provide more information and details that can be used by the different stakeholders for making decisions in an organization. In order to do this effectively, accurate interpretation and assessment of account needs to be carried out. A technique for doing this is ratio analysis, providing a more meaningful picture of the performance of a business. The following is going to explain what the financial ratio is, how to use it and critically evaluate it as an accurate assessment.
“Ratio analysis is an examination of accounting data by relating one figure to another, this allow more meaningful interpretation of the data and the identification of trends and performance. “(Marcouse, I Gillespie, A Martin, B Surridge M & Wall, N, 1999, P160) For instance, accountants express net profit as a percentage of net assets. Net profit, in this case, is a measure of performance, and net assets a measure of size. Thus, net profits as a percentage of net assets, is business performance in relation to the size.
Generally, a large organization is likely to obtain more profits than a small local shop because it has greater ability to sell more, so such as that Tesco’s net profit at 450 million is much better than a 20 million of regional food shop would be misleading. However, if profit as a percentage of net assets is shown, a different picture comes out. Tesco: 450m/1700m i?? 100% = 26. 47%; local food shop: 20m/65m i?? 100% = 30. 77%. According to figures, the local shop has used its assets more efficiently and effectively to making profits.
The pattern of operating of ratios has been used in the same way. Therefore, ratios would be expected more meaningful and useful when they compare with previous years and the competitors within the same size and same industry. The importance of ratios to stakeholders depends on who they are and what they are trying to find out. A potential shareholder will pay more attention into account of profits after tax of a firm and how much return on the capital employed or net assets. A bank manager would confirm if the firm has enough liquid assets to cover its short-term debts.
The sales director of the firm will be concerned with how many the sales in relation to the profits the firm has made. Thus the classifications of ratios are based on the different measurement of performance. These are divided into three groups namely performance ratios, capital ratios and shareholder ratios. Performance ratios are concentrated on how successful the organization has been in the field of sales and making profits from its trading position and activity. Some main ratios include return on net assets or capital employed, asset turnover, profits margin, stock turnover, debtors’ turnover and efficiency ratios.
Return on net assets or capital employed (RONA or ROCE) is “referred to as being the primary efficiency ratio and is perhaps the most important ratio of all”. (Marcouse, I Gillespie, A Martin, B Surridge M & Wall, N, 1999, P162) It measures the efficiency of using capital in running business. ROCE = operating profit/capital employed i?? 100% operating profit is profit after all costs, capital employed is long-term loans plus shareholders’ funds. There is no clear answer, the higher the better, but most companies would desire 20%.
Profits margin is given by the two formulas gross profit margin and net profit margin respectively: gross profit/turnover i?? 100%; net profit/turnover i?? 100%. A higher percentage result is preferred. They measure whether the firm has been efficient in control its overhead costs and expenses. This group ratio is often considered to measure the profitability and efficiency of a company. As the name suggested, capital ratios focus on the firm manages its capital in the short-term liquidity and in the long-term gearing. This group contains current ratio, acid test ratio and gearing.
Current ratio measures a company’s short-term financial position given by the formula: current assets/current liabilities i?? 100%. The ideal current ratio should be around 1. 5:1, a low current ratio means the company may not be able to pay its debts. Gearing = long-term loans/capital employed i?? 100%. The higher the gearing the higher the degree of risk. “If loans represent more than 50% of equity, the company is said to be highly geared. ” (Marcouse, I Gillespie, A Martin, B Surridge M & Wall, N, 1999, P165) Ratios in this group are very useful to measure the company’s liquidity and solvency.
Shareholder ratios such as earnings per share (EPS), PE ratio and dividend yield, are specifically concerned with the profit attributable to the owners and related to their investment. The ratios are concentrated more by shareholders and potential investors. They provide information of judging whether the shares are expensive or not, and whether the dividends are desirable. As above mentioned, ratios can be adopted by management in assessing and analysing business performance due to their strength-“a quick and simple way to get an instant view of the whole business”.
(Business handout, 2004) However, as with any statistics, in any field, the only real way to draw a conclusion from information provided is to make comparisons, so just saying that a HEFP student got 65%(distinction) in a economics causework, the general consensus might consider that this is a good result, but further analysis may show that the student may not be satisfied by the result because 80% student is over 65% or this is his lowest mark compared with other subjects or his previous results.
Thus, the new conclusion drawn would be more critical of his performance, except that this was the worst subject for him or he expected to get only 60%. The same type of situation also exists in the real business world. Assume that Marks ; Spencer’s got a 30% ROCE (return on capital employed) last year is a favourable result, compared with other firms in the same industry had an average ROCE of 27%.
This was also their highest ROCE during the past five years. However, the company’s directors, who had put more investment in new products over recent years and expected a return of 35%. Therefore, an accurate assessment of performance should be judged carefully and depended on many different factors.